Red-Blooded Risk: The Secret History of Wall Street

An innovative guide that identifies what distinguishes the best
financial risk takers from the rest

From 1987 to 1992, a small group of Wall Street quants invented
an entirely new way of managing risk to maximize success: risk
management for risk-takers. This is the secret that lets tiny
quantitative edges create hedge fund billionaires, and defines the
powerful modern global derivatives economy. The same practical
techniques are still used today by risk-takers in finance as well
as many other fields. Red-Blooded Risk examines this
approach and offers valuable advice for the calculated risk-takers
who need precise quantitative guidance that will help separate them
from the rest of the pack.

While most commentators say that the last financial crisis
proved it's time to follow risk-minimizing techniques, they're
wrong. The only way to succeed at anything is to manage true risk,
which includes the chance of loss. Red-Blooded Risk presents
specific, actionable strategies that will allow you to be a
practical risk-taker in even the most dynamic markets.

Contains a secret history of Wall Street, the parts all the
other books leave out

Includes an intellectually rigorous narrative addressing what
it takes to really make it in any risky activity, on or off Wall
Street

Addresses essential issues ranging from the way you think about
chance to economics, politics, finance, and life

Written by Aaron Brown, one of the most calculated and
successful risk takers in the world of finance, who was an active
participant in the creation of modern risk management and had a
front-row seat to the last meltdown

There are people who disapprove of every risk before the fact,
but never stop anyone from doing anything dangerous because they
want to take credit for any success. The recent financial crisis
has swelled their ranks, but in learning how to break free of these
people, you'll discover how taking on the right risk can open the
door to the most profitable opportunities.

Aaron Brown is risk manager at AQR Capital Management and the author of The Poker Face of Wall Street (Wiley), selected one of the ten best books of 2006 by BusinessWeek, and A World of Chance with Reuven and Gabrielle Brenner. In his thirty-year Wall Street career, he has been a trader, portfolio manager, head of mortgage securities, and risk manager for institutions including Citigroup and Morgan Stanley. He also served a stint as a finance professor and was among the top poker players in the world during the 1970s and 1980s. He holds degrees in applied mathematics from Harvard and in finance and statistics from the University of Chicago.

"Wickedly original, one of the most fascinating accounts I have
ever seen. A rollicking and highly opinionated read." (Risk
Professional, October 2011)

“No one who reads Red-Blooded Risk: The Secret History of
Wall Street will ever again regard risk management as a
necessary but unproductive appendage of the financial industry.
Other authors have chronicled how quantitative finance influenced
investment management, but Aaron Brown has made a compelling case
for a far more profound economic impact. . . If Red-Blooded
Risk: The Secret History of Wall Street dealt with nothing more
than the inadequacy of models used in highly important activities,
it would represent a valuable contribution to financial economics.
Brown’s book, however, covers a great deal more than
econometric malpractice. Probably no other book offers as much
insight into the process with so little resort to mathematical
notation. Especially valuable are Brown’s discussions of
middle-office risk management and value at risk, comparatively
recent innovations that are essential to understanding modern
financial institutions. Readers of Red-Blooded Risk should
be prepared to have many of their assumptions challenged.
Red-Blooded Risk is one of the most original and
thought-provoking books reviewed in these pages in the past 20
years. No one who reads it will ever again regard risk
management as a necessary but unproductive appendage of the
financial industry. Other authors have chronicled how quantitative
finance influenced investment management, but Aaron Brown has made
a compelling case for a far more profound economic
impact.”
—Martin S. Fridson, CFA Institute Publications
Book Reviews
“Red-Blooded Risk mixes risk history and philosophy
nimbly and provides a perspective that can be both refreshing and
challenging (often on the same page). While the book is not without
weaknesses, it is also brimming with original perspectives and
controversial opinions. Those who work in risk management or
quantitative finance will enjoy Brown’s story-telling and
expert perspectives, even if they do not share his views, while
non-quants will find his insights and confessions to be a useful
glimpse into the psyche and ethos of an influential group of early
quantitative risk takers.
—Roger M. Stein, Research and Academic
Relations, Moody’s Corporation, as reviewed in
Quantitative Finance (August 6, 2012)

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In emotional terms, thin-blooded people are motivated mainly by fear, hot-blooded people by anger and other passions—or even merely thrills—and cold-blooded people by greed. Red-blooded people feel anger, fear, and greed like anyone else, but understanding successful risk taking is a matter of calculation, not instinct. Red-blooded risk managers utilize specific mathematical techniques to turn any situation into a system with clearly delineated risks, dangers, and opportunities; optimize the risks for the best possible outcome; and arrange things so both dangers and opportunities make the maximum positive contributions.

In RED-BLOODED RISK (Wiley; October 2011; $34.95; 978-1-1180-4386-8; Hardcover; Also Available in Ebook Formats), Aaron Brown, risk manager at AQR Capital Management, offers a treatise on the theory, history, and practice of managing risk, as well as advice for the calculated risk-takers who need precise quantitative guidance that will help separate them from the rest of the pack.

The book follows several themes, which build and interconnect to provide a diverse picture of risk:

The Secret History of Wall Street: In the 1970s, young mathematicians (soon to be known as “quants”) were disillusioned by what they saw as the hypocrisy of many conventional quantitative thinkers in that they were unwilling to bet personally significant stakes on the results of their analysis. They invented a new way of looking at probability and set out to prove it in the ultimate testing ground of odds-making: Las Vegas.

Once there, the quants turned conventional wisdom about gambling on its head. People said you can't beat the house, yet the quants managed to beat blackjack and other casino games. People said you needed a lifetime to learn poker, yet the quants' aggressive mathematical tactics swept the table against the best players in the world. Then they turned to sports betting, overturning the business model and squeezing out local bookies with a global organization that matched bets without taking risk.

Armed with their theories and experience, the quants raised their sights and headed to Wall Street, determined to replicate their success. Finance was a tougher challenge than gambling, but by the mid-1990s, they had remade Wall Street as thoroughly as they had remade Las Vegas. That transformation went unnoticed by the bond salesmen and investment bankers who ran Wall Street, as well as by academics, regulators, journalists, and investors; yet these changes caused both the greatest wealth creation event in the history of the world and the financial disasters witnessed in its wake.

The Theory and Philosophy of Risk: Brown tackles the paradox of the two opposing camps of probability: frequentists, whose fundamental definition of probability rests on repeatable experiments, and Bayesians, whose foundation is subjective degree of belief, and how they have fused together in practice. He also considers the importance of Pascal’s wager and how it relates to risk, the seven principles of risk management, efficient markets, exponentials and how risk-avoiding people often use them recklessly, and the work of Harry Markowitz and John Kelly in the 1950s.

The Story of Money: Since money is essential to managing risk, Brown examines it in depth, starting with a discussion of the idea of property and how it has led to exchange. Until someone owned something, nothing could be exchanged. He then looks how money has transformed, from the development of gambling and equal-value exchange in the Upper Paleolithic Era to the creation of paper money by the Romans to how the American colonists created low-quality money to pay for the Revolutionary War and the creation of futures contracts around 1850, when boards of trade appeared in the major cities. He then argues that derivatives are the new money in the modern economy and addresses this in the context of the fall of Lehman Brothers. Brown asks “If paper money will fade to insignificant economic importance to be replaced by derivative-like arrangements, how will this affect the nature of risk taking?”

What a Risk Manager Does: Incorporating his own experience, Brown addresses how risk management is organized within a finance-related company, from a front-office risk manager, including sales and trading, asset management, retail financial services, institutional financial services, lending and investment banking, to back office, which involves compiling what has become a huge volume of risk reports for decision makers, regulators, and investors, and the middle office, which is designed to create two information loops in the bank, focusing on information that is vital to companywide risk.

The book assesses the tools of the trade, including Value at Risk (VaR), which almost all financial risk managers use as a primary component of their processes; stress testing and scenario analysis, which concentrate on dramatic external events that could harm the firm; and the employment of mathematical techniques to identify losses that occur from unexpected combinations of events that are not individually unlikely. He also explores why risk manager failed to prevent the financial crisis and provides his list of risk “unspeakable truths,” including risk managers should make sure firms fail; there’s good stuff beyond the VaR limit; and risk managers create risk.

The Illustrated Side of Risk: Brown has teamed up with renowned manga artist Eric Kim, who has provided multiple comics, from depicting the story of money and applying VaR to surviving in the jungle to the ongoing saga of red blood (the heroine who understands risk) and the other bloods (blue, cold, hot, thin and risk manager blood sucker, among others) who fall prey to taking too much risk out of greed or arrogance or not enough out of fear.

Risk taking is not just a quantitative discipline; it is a philosophy of life. RED-BLOODED RISK demonstrates how embracing risk taking opportunities that offer a positive edge in the long run will result in expected outcomes.

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